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Before the
DEPARTMENT OF THE TREASURY
Washington, D.C.

Review of the Regulatory
Structure Associated With
Financial Institutions

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TREAS-DO-2007-0018

Comments of
The United States Department of Justice

The Department of Justice ("Department") is pleased to submit these
comments in response to the Department of the Treasury's ("Treasury's")
request for comments on the Regulatory Structure Associated with Financial
Institutions, 72 F.R. 58939, October 17, 2007.

SUMMARY

Based on its extensive experience investigating competitive conditions
in various financial markets, including financial futures, options,
and equities, the Department believes that certain regulatory policies
governing financial futures may have inhibited competition among financial
futures exchanges, potentially discouraging innovation and perpetuating
high prices for exchange services.(1)

More specifically, the Department believes that the control exercised
by futures exchanges over clearing services — including (a) where
positions in a futures contract are held ("open interest"), and (b)
whether positions may be treated as fungible or offset with positions
held in contracts traded on other exchanges ("margin offsets") —has made it difficult for exchanges to enter and compete in the
trading of financial futures contracts. If greater head-to-head competition
for the exchange of futures contracts could develop, we would expect
it to result in greater innovation in exchange systems, lower trading
fees, reduced tick size, and tighter spreads, leading to increased trading
volume.

In contrast to futures exchanges, equity and options exchanges do not
control open interest, fungibility, or margin offsets in the clearing
process. This lack of control appears to have facilitated head-to-head
competition between exchanges for equities and options, resulting in
low execution fees, narrow spreads, and high trading volume.(2)
Equities and options execution systems are also very sophisticated and
feature-rich, more so than futures contract execution systems.

Although characteristics of the equities and options markets differ
from those of financial futures markets, the clearing processes and
related regulatory framework in equities and options markets appear
to provide useful lessons in the futures arena. In light of the potential
competitive benefits that could flow from regulatory changes that would
facilitate competition in financial futures exchange markets, the Department
recommends that Treasury propose a thorough review of futures clearing
and its alternatives.

In these comments, the Department outlines its experience with competitive
issues in financial markets and provides background information on futures
markets. We then provide an overview of the competitive effects of exchange
control of open interest, fungibility, and margin offsets, and how current
policies may have inhibited execution competition. We specifically examine
several failed efforts to enter financial futures markets and how efforts
to enter were made more difficult by current clearing policies. We next
discuss how options and equities clearing policies differ and have enabled
beneficial trading venue competition. Finally, we consider whether there
are significant benefits that can only be achieved under the current
clearing arrangement.

THE DEPARTMENT OF JUSTICE'S EXPERIENCE WITH COMPETITIVE ISSUES IN
FINANCIAL MARKETS

The Department's experience spans the spectrum of financial markets,
including futures, over-the-counter derivatives, fixed income, foreign
currency, equities and options. In various sectors, the Department has
examined the underwriting process, front-end systems for delivering
information and data to market participants, execution systems, clearing
processes and settlement processes. We have conducted investigations
of potentially anticompetitive behavior by market participants, analyzed
the likely effect of proposed mergers, and reviewed claims relating
to intellectual property rights. The following investigations are especially
pertinent to the issues discussed herein.

Financial Futures.The Department recently
conducted an exhaustive investigation of the competitive consequences
of the Chicago Board of Trade's ("CBOT") acquisition by the Chicago
Mercantile Exchange ("CME").(3) The investigation
included examination of competition in futures markets, particularly
financial futures where CBOT and CME both offered products.

Equities.In collaboration with the Securities
Exchange Commission ("SEC"), the Department in 1996 investigated a quoting
convention among Nasdaq market makers that had the effect of significantly
increasing transaction costs.(4) Following
these investigations, the SEC promulgated order-handling rules that
made the securities order-execution process substantially more transparent.(5)
The Department's recent experience also includes investigations of the
Nasdaq/Instinet and NYSE/Archipelago mergers.

Options. Again in collaboration with the
SEC, the Department in 2000 investigated and challenged an informal
agreement among options exchanges not to list option contracts listed
on another exchange.(6) That effort led
to the widespread listing of option contracts on multiple exchanges
— spurring trading volume, increasing innovation, and significantly
reducing trading costs in options.(7)

BACKGROUND ON FUTURES AND FUTURES TRADING AND THE ROLE PLAYED BY
CLEARINGHOUSES

Futures were originally developed as a means of hedging risks in agricultural
commodities. In the 1970's, CBOT and CME introduced the first futures
contracts on interest rate products. Their products allowed purchasers
to hedge against volatility in the cost of capital and, when equity
index futures were first introduced in the 1980's, to hedge against
volatility in stock indices. In the recent past, futures exchanges have
developed new financial futures contracts that commoditize over-the-counter
("OTC") traded products, particularly interest rate swaps and credit
default swaps.

These uses of futures contracts continue today. While some traders
use futures to speculate on future price movements, many others buy
futures to hedge various types of risk, taking positions in futures
to balance a portfolio or to minimize the risk to their portfolio from
future price changes. Such hedgers seek futures products that closely
match the risk profile of the positions they hold, and for them the
differences between OTC products and futures in terms of cost, transparency,
accessibility, and liquidity means that OTC products are only rarely
good alternatives. As a result, futures contracts that address a given
risk profile, the 10-year Treasury note future, for example, cater to
a distinct market demand.

For buyers and sellers, the most important aspect of trading cost in
futures is a contract's bid/ask spread, which is primarily a function
of the availability of ready and willing buyers and sellers. All else
being equal, the more buyers and sellers, the more liquid a market,
and the tighter the bid/ask spread. Such "spread costs" are several
orders of magnitude greater than other costs buyers and sellers incur,
including separate fees paid to exchanges for executing transactions.

Once a buyer or seller has executed against a price quoted on an exchange,
contract novation occurs, with the clearinghouse stepping in to be the
counterparty to both sides of the transaction. This clearing process,(8)
in futures as well as equities and options, involves several steps.
First, unless the trade is "locked in," the clearinghouse will compare
the details of the transaction between buyers and sellers (or their
brokers) to ensure the terms match.(9)
The clearinghouse then aggregates related transactions of each member
and identifies offsetting commitments, e.g., buys and sells
in the same instrument, to establish a member's net liability and the
net liability of the clearinghouse. Futures (and options) clearinghouses
also ensure satisfaction of the terms of the contract by becoming the
counterparty on each side of every trade, thus guaranteeing contract
performance.(10) Clearinghouses also
ensure transactions are settled.(11)
Futures clearinghouses protect themselves from loss by requiring a good
faith deposit (initial margin) to the clearinghouse of the member firm,
and additional deposits (maintenance margin) as the value of the underlying
position varies.(12) Maintenance margin
is set by calculating the value of outstanding contracts and recording
the value of maturing contracts. This process of "marking to market"
effectively results in a revaluation (and settlement) of profits and
losses of outstanding futures contracts on at least a daily basis.(13)
By collecting additional margin, clearinghouses are able to cover prospective
changes in the value of the portfolio.(14)

THE EFFECT OF CURRENT RULES AND POLICIES RELATING TO CLEARING OF
FINANCIAL FUTURES ON COMPETITION AND CONSUMERS

Under the current regulatory regime, an exchange controls where a financial
futures contract is cleared and whether the clearinghouse may treat
contracts as fungible or eligible for margin offset. There is reason
to believe that this structure, interacting with the importance to traders
of exchange liquidity, makes it more difficult for exchanges to introduce
new financial futures products capable of providing sustained head-to-head
competition against existing products. Competition in futures markets
has tended to be limited to the introduction of new products, with the
competition occurring only briefly as multiple exchanges attempt to
establish themselves. The typical pattern has involved one of these
exchanges attracting almost all liquidity in the product, leading the
other exchange to cease offering a directly competitive futures product.

If exchanges did not control clearing, an appropriately regulated clearinghouse
could treat contracts with identical terms from different exchanges
as interchangeable, i.e., fungible. The incentives of such
a clearinghouse would be to maximize its own profits, and it thus likely
would treat identical contracts as fungible.(15)
In a world of fungible financial futures contracts, multiple exchanges
could simultaneously attract liquidity in the same or similar futures
contract, facilitating sustained head-to-head competition. A trader
could open a position on one exchange and close it on another.(16)
In such a world, a trader could execute against the best price wherever
offered without fear of being unable to exit the position because there
is insufficient trading interest (or of being forced to exit at a poor
price) on the new entrant trading venue when a trader chooses to exit.(17)

In addition, if exchanges did not control clearing, an appropriately
regulated clearinghouse could reduce member margin obligations by recognizing
offsetting positions in correlated financial futures contracts traded
on different exchanges. The ability to offset correlated positions in
a futures clearinghouse can significantly reduce the capital required
to trade. For example, CME's clearing division — where the vast
majority of statistically price-correlated financial futures positions
are currently consolidated — offers its members margin offsets
for related asset classes, thereby reducing risk collateral requirements,
which results in savings to buyers and sellers unavailable on other
exchanges.(18)

Accordingly, we would expect that a change in the regulatory regime
that eliminated exchange control of the clearing function would facilitate
the emergence of greater competition between exchanges. The CFTC's regulatory
policies, which have permitted exchange control of clearing, are not
mandated by the Commodities Futures Modernization Act of 2000 ("CFMA").
We therefore urge Treasury to propose a thorough review of futures clearing
and its alternatives, including a careful examination into whether a
regime more similar to that in the equities or options markets is feasible
and would lead to significant consumer benefits.

Current Regulation and Policy on Financial Futures Clearing

Today, exchanges control clearing of financial futures contracts. The
current structure of financial futures markets in the United States
was put in place in the early 20th century when the Chicago Board of
Trade Clearing Corporation ("BOTCC") began intermediating agricultural
futures contracts on behalf of CBOT, thus assuming the risk of non-delivery
from the exchange.(19) When futures
exchanges subsequently were subject to regulation with the enactment
of the Commodities Exchange Act ("CEA"), no provision of that statute
expressly granted CFTC authority to regulate futures clearing. What
regulation there was of clearing had developed indirectly through the
CFTC's oversight of those futures exchanges that had affiliated with
clearing systems.(20) When financial
futures products were introduced in the 1970's, the CFTC maintained
its approach to clearing and thereby did not prohibit the application
of the then-prevailing exchange-controlled clearing model to financial
futures.

The CFMA(21) revamped the futures regulatory
structure, giving the CFTC explicit authority over clearing in futures
markets and creating a new requirement that clearinghouses register
with the CFTC. As a result, the CFMA, for the first time, provided for
the separate regulation of execution and clearing.

The CFMA required the CFTC to conduct a study of the CEA and the Commission's
rules and orders governing the conduct of registrants under the Act.(22)
In its Report, the CFTC noted that a number of commenters had raised
issues relating to clearing, including the desirability of changes in
regulatory policy that would permit futures contract fungbility and
require clearinghouses to be independent of the exchanges for which
they clear.(23) The CFTC concluded that
the CFMA did not mandate a change in its traditional policy of exchange-controlled
clearing.(24) Recognizing the importance
of the issue, however, the CFTC did announce a plan to conduct a roundtable
of industry participants, at which the CFTC's role in encouraging competition
in the futures industry, including common clearing and fungibility were
to be primary issues.(25) At those hearings,
a variety of industry participants, including representatives of the
Futures Industry Association, major futures firms, and some exchanges
called for an end to exchange control of clearing.(26)
The CFTC did not take formal action in response to these requests to
end exchange control of clearing, but it has since approved CBOT Rule
701.01, which required CBOT members to transfer open interest from BOTCC
to CME Clearing and thereby gave CBOT ongoing control of futures contracts.(27)

The Department believes that adopting a regulatory policy that fosters
exchange competition by, inter alia, ending exchange control
of financial futures clearing would be consistent with the objectives
of the CFMA. The CFMA directs the CFTC to prevent the adoption of exchange
or clearinghouse rules that unreasonably restrain trade or impose a
material anticompetitive burden on the markets,(28)
and directs the CFTC to facilitate the linking of futures clearinghouses
with other regulated clearance facilities.(29)
In the Department's view, these provisions reflect Congress' desire
to stimulate competition between exchanges and between clearing organizations.

The Current Market Structure Has Impeded Successful Entry.

Under the current clearing framework, competition tends to be limited
to that which occurs when a new contract, i.e., one addressing
a market risk not addressed or not adequately addressed by existing
products, is introduced. The introduction of a new contract by one futures
exchange frequently prompts another exchange to offer a similar contract,
and a battle to garner all the liquidity in the contract ensues. After
one exchange wins most of the liquidity in the contract, the other exchange
usually exits. In its investigations, the Department has found that,
in each significant financial futures contract traded in the United
States, one exchange has virtually all of the liquidity. Using the 10-year
Treasury note future as an example, CME has a market share of essentially
100%. The "winner-takes-all" character of futures exchange competition
is a function of liquidity: the more liquid the market, the greater
the chance of execution at favorable prices. As a result, the market
for a particular contract will tend to concentrate on a single exchange.
This in turn gives the exchange a marked advantage over smaller firms
and new entrants.(30)

While network effects provide a significant impetus toward the concentration
of trading in any particular type of futures contract on a single exchange,
they are not by themselves an insurmountable barrier to competition.
Liquidity network effects of this sort have been successfully overcome
in financial markets where regulatory policy facilitates competition
among exchanges.(31) In financial futures
markets, however, efforts by competitors to overcome an initial liquidity
disadvantage are further handicapped by the liquidity advantages of
incumbent exchanges that flow from their control of clearing. Specifically,
the Department believes that the control of clearing by incumbent futures
exchanges prevents buyers and sellers from accessing existing liquidity
if they trade the same (or highly correlated) contract on another exchange,
thereby making it significantly more difficult for entrants to gain
sufficient liquidity to provide sustained competition with the incumbent.

Efforts over the last decade by exchanges to enter the U.S. financial
futures markets with products that competed head-to-head with existing
products, all of which failed, show the effect of exchange-controlled
clearing and the potential competitive benefits of successful entry.
In a number of instances where entry has been attempted, the prospect
of entry forced a substantial, but only temporary, competitive response
from the incumbent exchange. These competitive responses benefitted
the market, but those benefits proved transitory because, under the
existing regime of clearing, the entrant was unable to establish sufficient
liquidity to maintain a sustained competitive presence and exited the
market.

BrokerTec's entry into Treasury futures.

BrokerTec Futures Exchange ("BTEX") was formed in 2000 as a joint venture
of several large investment banks.(32)
It listed futures and options on futures electronically in the Treasury
bond and note complex, competing directly against the CBOT. An affiliated
company, BrokerTec Clearing Company, cleared its transactions. BrokerTec
Clearing members were allowed margin offsets for positions opened at
CBOT in U.S. Treasury futures at CBOT, but CBOT did not respond to BTEX's
request that it amend its margin rules to permit its clearinghouse,
BOTCC, to reciprocate.(33) As a result,
buyers and sellers on BTEX were required to bear the increased costs
of posting capital for offsetting CBOT and BTEX positions when those
positions were held on BOTCC, but not when those positions were held
in BrokerTec Clearing. The prospect of electronic competition from BTEX
spurred CBOT to enter into a joint venture with Eurex on an electronic
futures trading platform in the United States, causing a significant
shift to electronic trading in Treasury futures contracts, and reducing
fees.(34) The shift to electronic trading,
in turn, resulted in increased trading volume.(35)
BTEX failed to attain any meaningful share of the Treasury futures market
and was subsequently purchased by Eurex US.(36)

Eurex US' entry into Treasury futures.

In January 2003, CBOT announced its plan to dissolve its electronic
trading platform joint venture with Eurex and obtain platform services
from another vendor. Eurex in turn announced its intention to provide
an electronic Treasury futures exchange in competition with CBOT once
the parties' non-compete agreement expired in February 2004.(37)
To facilitate this entry, Eurex was widely believed to be in discussions
with BOTCC, which was CBOT's clearinghouse at the time, to clear its
futures contracts.(38) This ultimately
resulted in CBOT entering into an agreement with CME for clearing of
CBOT traded futures.(39) That contract
required the transfer of open interest from BOTCC to CME Clearing.(40)
This requirement was transmitted to the CFTC on July 2, 2003, in the
form of a rule proposal and approved shortly thereafter.(41)

Against this backdrop, Eurex's attempted entry was unsuccessful. Eurex's
subsidiary, U.S. Futures Exchange, LLC. ("USFE"), was approved by the
CFTC as a new exchange in February 2004 and began listing futures and
options on futures on Treasury bonds and notes shortly thereafter.(42)
Eurex invested significant funds into the Treasury product — in
the form of market making and other trading incentives — in an
attempt to attract liquidity to its platform.(43)
While USFE's application to offer exchange services was pending before
the CFTC, CBOT announced that it was cutting transaction fees 54% for
members and 20% for non-members.(44)
Subsequently, CBOT reduced its electronic trading fees for its U.S.
Treasury complex even further — exchange members received a six-month
fee waiver (effectively taking their fee to zero), and non-member fees
were reduced to 30 cents per side for futures and fifty cents per side
for options on futures, a reduction of about 65%.(45)
CBOT also announced a liberalization of membership requirements to allow
more firms to qualify as members and receive the lower membership fees.(46)

Despite these procompetitive responses by CBOT, USFE had some initial
success, gaining about five percent of the market. By mid-2005, however,
USFE admitted defeat, stating that its window of opportunity for Treasury
products had passed and that it was turning its attention to foreign
exchange futures.(47) Shortly after
USFE's announcement, CBOT raised its fees for non-member trades by 50%
and its fees for electronic transactions from three to five cents a
contract.(48) In July 2006, CBOT raised
clearing fees for its financial futures contracts.(49)
CBOT raised exchange fees again in October 2006 for non-member trading
of its Treasury complex.(50)

Euronext.Liffe's entry into Eurodollars

In late 2003, it was widely believed that CME would face competition
from a European futures exchange in its core Eurodollar futures contract.(51)
In anticipation of this entry, CME reduced its electronic system trading
fees by 60% for CME members, clearing members and their affiliates.(52)
It also established a market maker program on Globex — its electronic
trading system — to provide market quotes after business hours,
which it extended to regular business hours in March 2004.(53)
Later it waived fees for certain large traders.(54)
In March 2004, Euronext.Liffe announced that it planned to enter the
market. Euronext's Eurodollar contracts would be available world-wide
on Liffe.Connect — its electronic trading platform — and cleared
through LCH-Clearnet, a London-based clearinghouse.(55)
Margin offsets would be available with Euronext's principal contract
— the European equivalent to the Eurodollar.(56)

By June 2004, Euronext appeared to have achieved significant success,
with the execution of several large block trades that amounted to a
large scale transfer of open interest in Eurodollar contracts from CME
to LCH.(57) However, CME was able to
block further transfers by adopting a rule, under its authority as a
self-regulatory organization, that forbade such trades as "fictitious."(58)
The rule was certified as consistent with the CEA by the CME, such that
it went into effect immediately. Liffe challenged CME's action before
the CFTC; the CFTC sought information from the parties to the dispute,
but has not ruled on the merits.

Euronext.Liffe's failure illustrates the difficulty of entering U.S.
futures markets against an established incumbent with entrenched liquidity.
Despite Euronext.Liffe's substantial European presence and margin offset
opportunities in a comparable product, its entry failed because the
U.S. incumbent was able to prevent the transfer of open interest. Nevertheless,
the temporary benefits of its attempted entry were substantial. In addition
to a significant lowering of trading fees, Euronext-Liffe's entry resulted
in significantly reduced bid-ask spreads and increased trading volume.(59)
It also resulted in a substantial shift to electronic trading in Eurodollars.(60)

While Euronext continues to list Eurodollar contracts, since early
2005 it has not had a significant competitive presence in Eurodollar
products, as there has been almost no open interest in Euronext's contracts
and no trading volume. CME was able to raise both clearing and execution
fees on August 1, 2005.(61)

* * *

One lesson of this brief history is that when entry into an existing
product by a second exchange has occurred, there have been substantial
beneficial effects — whether in lower prices, increased innovation,
or expanded choice. Another lesson is that exchange control over open
interest and clearing have impeded entry and the development of meaningful
competition in execution services.(62)
Given the benefits of exchange competition, examining potential changes
in regulatory policy appears warranted, unless it were clear that there
are no viable alternatives to the current financial futures structure
or that the current structure provides overriding benefits that justify
its retention. Whether there are equally good alternatives can be informed
by examination of the equities and options markets, which we examine
in the next section. Section D below considers whether there are clear
benefits that are achievable only under the current clearing framework.

Equities and Options Exchanges Have Different Execution/Clearing
Structures That Have Facilitated Exchange Competition

Options. The options market has a single
regulated utility — the OCC — which serves as the clearinghouse
for all exchanges and their members. The OCC was formed in 1973 when
the Chicago Board Options Exchange listed the first stock option. In
1975, when the American Stock Exchange sought to offer an option on
other stocks, the SEC directed that the OCC clear its trades. As a result
of SEC policy, the OCC, jointly owned by the options exchanges, clears
all option trades. In addition, in 1990, the SEC adopted Rule 19c-5,
which permitted option exchanges to list equities options listed on
another exchange.(63) The listing of
options by multiple exchanges was (and is) possible because the OCC
substitutes its capital and resources for those of the parties in every
transaction — becoming the buyer to every seller and the seller
to every buyer. Because the clearinghouse serves as the universal counterparty,
market participants can open a position on one exchange and close it
on another. Because contract terms are generally set by the OCC,(64)
options contracts traded on one exchange are completely fungible with
those traded on another.

Rather than conform to the directives of Rule 19c-5, the then-four
options exchanges reached an understanding with one another to refrain
from listing equity options classes that were already listed on another
exchange. As a result, many frequently traded equity options were traded
only on one exchange for most of the 1990s, like futures contracts are
today. Since the summer of 1999, when SEC and Department investigations
became public,(65) options exchanges
have actively competed in the listing of equity options. The benefits
of this competition have been substantial and lasting.

Two new options exchanges have entered the market, one of which —
the International Stock Exchange — has become the largest options
venue. Spreads narrowed by 30-40% within six months of its entry,(66)
and have continued to fall since.(67)
With this competition, options volume is growing rapidly. Approximately
200 million contracts trade per month, more than four times the average
monthly volume in mid-1999,(68) and,
as of 2006, all of the six options exchanges were experiencing increased
growth with no single exchange having more than a third of the total
volume. In addition, the average trade size has been increasing, suggesting
increased involvement of institutional investors in what historically
was a market dominated by retail investors.(69)
Increases in trading volume have even occurred in times of decreasing
market volatility — times when options trading historically has
decreased.(70) Moreover, new trading
systems have proliferated, execution fees have been substantially reduced,
and exchanges have developed a host of service and system innovations
to expedite order execution and settlement.(71)

Equities. In the 1960s, when regional exchanges
provided alternate venues for trading stocks listed on NYSE, clearing
functions were operated by each exchange, as they are now in futures
markets. With the Securities Act Amendments of 1975, the SEC was directed
to facilitate a national system for clearance and settlement of securities
transactions. Congress' objective was that the several clearing systems
be interconnected and operate under uniform rules.(72)
Shortly after the amendments, the NYSE, Amex and NASD agreed to establish
a jointly owned entity to take over their clearing operations, which
led to the incorporation of the NSCC. In approving the NSCC's application
for registration as a clearing agency, the SEC imposed a number of conditions,
including requiring NSCC to establish appropriate links to the regional
exchanges' clearing agencies.(73) Over
time, regional exchanges have discontinued their clearing operations
in favor of clearing through the NSCC.(74)
In addition, at the SEC's direction, exchanges submitted rules which
provided for the recision of any rules tying the clearance and settlement
of transactions to clearing agencies affiliated with the marketplace.(75)

Like options market clearing, equities clearing facilitates exchange
competition. When a trade occurs, the parties to the trade provide the
exchange or electronic venue with the name of their registered clearing
brokers who are, in the first instance, responsible for contract performance.(76)
The transaction is then sent to the NSCC which clears for almost all
equity exchanges and electronic trading venues in the U.S. Securities
held by NSCC members that can be transferred within the Depositary Trust
Co. are eligible for continuous net settlement at the NSCC. NSCC then
becomes the counterparty to each trade, guaranteeing that both the obligation
to deliver securities and the obligation to make payment. As a result,
once listed on an exchange, a stock may be traded on multiple trading
venues, with a market participant purchasing it on one venue and selling
it on another.(77) The process is subject
to SEC regulation.

This structure — and its regulatory overlay — permits multiple
exchanges and electronic trading venues to offer the same or equivalent
instruments. There is significant competition among multiple equity
trading venues, with low execution fees, narrow spreads, and widespread
system innovation — all to the benefit of consumers.(78)
One study found that the NYSE's entry into trading of ETFs led to double-digit
percentage declines in bid-ask spreads.(79)

The Department recognizes that there are significant differences in
equities, options and futures trading. Nevertheless, the experience
in options and equities markets appears to provide useful lessons for
the potential role of exchange competition if regulatory policy relating
to clearing by a futures exchange were changed.

There Do Not Appear to Be Any Overriding Benefits of Preserving
the Current Regime of Futures Clearing.

The Department is aware of three principal arguments in favor of the
current regime of exchange controlled clearing in futures markets: (1)
that sufficient reward to promote innovation can only be assured if
replica contracts are kept off the market and that exchange controlled
clearing helps achieve that objective;(80)
(2) trading of futures on multiple exchanges could adversely affect
traders by fracturing liquidity and diminishing market depth; and (3)
the current system minimizes the risk of default.

The first contention, that the current structure is necessary to provide
exchanges an incentive to innovate new futures contracts, boils down
to the contention that competition is inconsistent with incentives to
innovate. In fact, however, experience indicates that competition can
spur firms to innovate by developing new products or making their existing
products more attractive (including though product change as well as
reduced prices and improved quality).(81)
Thus, any study of regulatory change that would eliminate exchange control
of clearing would need to consider the important incentives that may
be created by competition.

A second argument offered in favor of preserving the current regime
is that a change in regulatory policy that would facilitate the trading
of futures contracts on multiple exchanges would adversely impact buyers
and sellers by fracturing liquidity, diminishing market depth and price
transparency, and by making it more difficult for buyers and sellers
to find the best price to execute transactions. The market response
to Eurex's and Euronext.Liffe's suggests that such concerns are not
well founded. In both cases, new entry coincided with substantial increases
in trading activity in the products traded.(82)
Experience with new entrants in the options and equities markets is
to the same effect. In each case, market volumes increased and all indicators
of market performance — fees, volume, spreads — either improved
or did not change. Indeed, experience in options markets suggests that
the likely effect of a change would be significantly lower exchange
fees, narrower spreads, and greater trading volume.

A third argument is that the current system reduces risk to the market
of participant default as transparency of market exposure is enhanced
when related market positions of individual customers can be captured
in one place. Exchange control of where products are cleared, however,
does not appear necessary to achieve this result. Both
the options and equities models have successfully protected investors
from default.(83)

CONCLUSION

The Department believes that current rules and policies related to
clearing futures contracts may be unnecessarily inhibiting competition
among futures exchanges in the development and trading of financial
futures contracts, to the detriment of the economy and consumers. Unnecessary
restraints on competition threaten the ability of the U.S. financial
markets to adapt to changing dynamics, including the increasingly global
nature of those markets.

The Department believes that significant benefits might be achieved
if regulatory policy were changed so as to foster exchange competition
by, inter alia, ending exchange control of clearing (in conjunction
with appropriate regulation to ensure that clearinghouses could not
in turn exercise market power). The clearing structure and regulatory
framework in the equities and options markets are instructive. If regulatory
policies that encourage and facilitate exchange competition were adopted,
futures clearinghouses would likely clear for multiple exchanges and
treat identical contracts as fungible.(84)Futures exchanges would, in turn, compete in terms
of price, quality of execution systems and the speed and completeness
of information available to market participants. Futures markets would
become more transparent and market risk would likely be more widely
distributed as new participants are attracted to trading opportunities
in the futures markets. The Department therefore recommends that Treasury
undertake a careful and objective review of exchange-controlled clearing
of financial futures, the regulatory structure that underlies it, and
its alternatives.

1. Our comments are directed solely at competitive
issues raised by financial futures markets. Markets for commodities
futures, such as energy futures markets, are outside the scope of this
comment.

2. As discussed below, clearing in options is through
the Options Clearing Corp. ("OCC") and clearing in equities is largely
through the National Securities Clearing Corp. ("NSCC"). The Department,
in filing this comment, does not address the competitiveness of clearing
markets in equities, options, or futures. Rather, the focus of
this comment is on the effect current futures clearing policy has on
the competitiveness of trade execution markets.

3. The Department ultimately determined that, although
the two exchanges account for most financial futures (and, in particular,
interest rate futures) traded on exchanges in the United States, their
products are not close substitutes, seldom competed head-to-head, and
that the parties were unlikely to introduce new products that competed
directly with the other's existing products. See Statement of the
Department of Justice Antitrust Division on its Decision to Close Its
Investigation of Chicago Mercantile Exchange Holdings Inc.'s Acquisition
of CBOT Holdings, Inc., June 11, 2007 (http://www.usdoj.gov/atr/public/press_releases/
2007/223853.htm).

8. Clearing is performed by an organization (or
clearing division of an exchange) created to clear and settle all the
transactions within a market or on an exchange. Its members (usually
large securities firms) deal directly with the clearinghouse but also
act as intermediaries for other securities firms in clearing their trades.

9. Matching is unnecessary for locked in trades.
Almost all equities trades are locked in when reported to the clearinghouse,
because the terms of trade are captured by the electronic system on
which the trade occurs. Many options trades and futures trades are also
locked in.

10. To fulfill this role, the clearinghouse maintains
a list of traded products, trade terms and persons eligible to trade
each product.

11. Settlement is a reference to completion of
a transaction by, in equities, delivery of securities to the buyer and
payment to the seller or, in futures and options, carrying out the terms
of the contract or offsetting it. The vast majority of futures contracts
are closed out before they reach expiration as the risk exposure of
the holder changes and settled for the difference in cash value between
the future and the underlying asset. For those that expire, i.e.,
mature, they may be either cash settled, like the Eurodollar futures
contract, or require delivery, like various Treasury futures, depending
on contract terms.

12. In futures markets, both the buyer and seller
must provide initial and maintenance margin. In options markets, only
the writer of the option must do so. Clearinghouses will engage in various
forms of market surveillance to manage and contain risk to the market.

13. By comparing a commodity's settlement price
yesterday versus its settlement price today a clearinghouse can establish
a value for outstanding futures contracts and determine whether changes
in market value require further contributions to a member's margin account.

14. CME's clearing division alone held more than
$46 billion in performance bonds in 2005. Whereas security deposits
serve as a back-up source of funding in the event of a clearing member
default, margin or performance bond requirements are the principal guarantor
of performance

15. Indeed, in 2003, the Board of Trade Clearing
Corporation ("BOTCC") sought to position itself to clear futures contracts
for more than one exchange. See note 39, infra. One
way in which regulators have fostered independent clearing is by prohibiting
tying of clearing services to trade execution services, as the SEC has
done with equities. See note 75 and accompanying text, infra.

16. When a clearinghouse assumes the performance
obligation, by substituting its capital and resources for those of the
parties to the initial transaction, market participants become indifferent
to the creditworthiness of the opposite party to the trade and can base
their buy or sell decision on other considerations. Because the clearinghouse
serves as the universal counterparty, market participants can close
out their positions and exit the market without having to seek out the
original parties (or the original exchange) to their opening trades.
This buying and selling of contracts that have not matured — the
"open interest" in that instrument — constitutes the secondary
market for that instrument.

17. The liquidity advantage has been made less
significant in equities markets by trading venue guarantees to route
transactions to markets with the best prices. These sophisticated routing
systems have effectively linked the liquidity on different venues creating
a single "virtual" liquidity pool.

18. When CME and CBOT combined their open interest
in 2003, they claimed that the combination resulted in $1.4 billion
reduction in performance guarantees for its members and $200 million
in reduced security deposits. Q3 2003 Chicago Mercantile Holdings,
Inc. Earnings Conference Call, Fin. Disclosure Wire, Nov. 5, 2003,
at 8. Consolidated clearing offers other efficiencies, including reductions
in clearing fees, the cost and frequency of collateral movements, the
number of bank transfers, the cost of intraday funding, systems development
and maintenance, and employee training costs associated with having
to interface with multiple, discrete clearing systems.

19. See James T. Moser, Contracting
Innovations and the Evolution of Clearing and Settlement Methods at
Futures Exchanges Federal Reserve Bank of Chicago, Working Paper
98-26 (August 1998).

20. The President's Working Group on Financial
Markets Report, Over-the Counter Derivatives Markets and the Commodity
Exchange Act Nov. 1999 at 15.

21. The CFMA generally followed the recommendations
contained in the Working Group's report. Congressional Research Service
Report, The Commodities Futures Modernization Act (P.L. 106-554)
Cong.R.S. 20560 (Feb. 3, 2003) (http://www.assets.opencrs/rpts/RS20560-20030203.pdf).

23. U.S. C.F.T.C., Report on the Study of the
Commodity Exchange Act and the Commission's Rules and Orders Governing
the Conduct of Registrants Under the Act (C.F.T.C. June 2002) at
23-24 (http://www.cftc.gov/files/opa/opaintermidiarystudy.pdf).

24. Id.
at 24. It concluded that: "The Act and Commission rules do not prevent
the adoption of fungibility or common clearing. Nor do they require
that the Commission mandate them."

25. Id. at 24. The CFTC Chairman at the
time, James Newsome, saw efforts to move the industry to common clearing
and fungibility as a business issue that he preferred the opposing sides
(futures commission merchants and futures exchanges) work out between
themselves. Richard Tsuhara and John McPartland, Clearing Structure
of the Derivatives Markets: We're Notin Kansas Anymore
23 Futures & Derv.L.R.1, 4, Oct. 2003.

adopting any rules or taking any actions that result in any unreasonable
restraints of trade; or

imposing any material anticompetitive burden on trading on the contract
market.

29. The CFMA added Sec. 5b(f)(1) to the CEA Act
which provides: "The Commission shall facilitate the linking or coordination
of designated clearing organizations registered under this Act with
other regulated clearing facilities for the coordinated settlement of
cleared transactions."

30. Trading on a single exchange can also reduce
market participant costs by facilitating "spread trading," the taking
of simultaneous offsetting positions in two correlated products, in
effect betting on the relative price movements (or "spread") between
the two products. Currently, traders can conduct spread trades across
different exchanges' products by using third-party trading software.
Such third-party supported spread trading entails, however, "execution
risk," the possibility that one leg of the spread trade will not find
a counterparty. When both products that compose the spread are offered
on a single exchange, execution risk can be eliminated by allowing the
offsetting transactions to trade as a single product, such that neither
leg executes unless both execute.

31. In two years, BATS has acquired approximately
10% of equities trading volume. Luke Jeffs, BATS Eyes European Markets
FinancialNewsOnlineUS, Oct. 29, 2007 (http://www.
financialnews-us.com/?contentid=2449054173&page=ushome). In the
options markets, the International Stock Exchange entered in 2000 and
by April 2003 had become the largest U.S. equities options exchange.
ISE Secures Position As Largest US Options Exchange
Mondo Visione, May 2, 2003 (http://www.mondovisione.com index.cfm?section=news&action
detail&id=423113)

36. See John Lothian, Eurex US's Great
Trade that Benefitted the Industry, June 24, 2005 (http://www.pricegroup.com/newsletter/062405.htm).

37. Jeremy Grant, Eurex to launch new derivatives
exchange in U.S. Financial Times UK, Jan. 10, 2003 (2003 WLNR 8225039).
Euronext.Liffe was announced as the new platform provider for CBOT.
Id.

38. Nothing prevented BOTCC from treating Eurex
products as fungible with CBOT's, or from allowing members to offset,
in their margin accounts, positions taken in Eurex contracts with those
taken in CBOT Treasury contracts. CBOT in talks with BOTCC over
Contract FT Investor Feb. 14, 2003.

39. CBOT demanded BOTCC enter into an exclusive
clearing agreement (thereby protecting the open interest that had originally
been executed on the CBOT exchange). When BOTCC did not respond, CBOT
began negotiating with CME. Eurex is said to be 'in talks' with
almost everyone — but nobody's talking Secs. Week Vol. 30
Issue 19 May 12, 2003 (2003 WLNR 3220693).

40. Sections 8 and 10.5 of the Clearing Services
Agreement, April 16, 2003. (Available, in redacted form, as Exhibit
10.3 to Chicago Mercantile Exchange Holdings, Inc. Form 10-Q (http://www.sec.gov/archives/edgar/data/1156375/000104746903027031/
a2116188zex-10_3.htm). Section 3.3 of that agreement gave CBOT sole
authority to determine whether contracts initially traded on CBOT could
be risk offset or treated as fungible with any other exchange's contracts.

42. C.F.T.C. Release 4886-04, CFTC Designates
New Exchange (C.F.T.C. Feb. 4, 2004) (http;//www.cftc.gov/opa/press04/opa4886-04.htm).
Eurex went forward with its plans, notwithstanding the transfer of CBOT's
open interest to CME, apparently on the expectation that it would be
able to undercut CBOT's execution fees and offer market participants
the ability to offset its U.S. product offerings with its European parent's
product offerings. Its proposal to create a single collateral pool for
U.S. and European products was never approved by the CFTC. Terry Stanton,
Eurex to offer FX Futures Hedgeworld Daily News June 16, 2005
(2005 WLNR 9582048).

43. David Roeder, Eurex Planning to Take on
Merc in Currency Trade Chicago Sun Times June 17, 2005.

59. See Tse and Bandyopadhyay, supra,
note 53. Effective bid-ask spreads on Globex, CME's electronic
platform, were reduced by approximately 30% in the seven months after
Euronext's entry. Id. at 335. Average effective bid-ask spread
for the period June 2003 to February 2004 were 7.43 percent, using one
mechanism for calculation, and 7.52, using another. For the period March
2004 through September 2004, the effective bid-ask spreads were 5.23
and 5.24, respectively. Id. In addition, monthly average trading
volume increased by 44 percent on CME, with a significant shift of trading
volume to electronic systems. Id. at 329. Floor trading volume
actually decreased 22%, while Globex trading volume increased 860%.
Id.

62. These issues were also addressed by the European
Competition Commission during its review of Deutsche Borse AG and Euronext
AV proposals to acquire the London Stock Exchange plc. It concluded
that full fungible access to an incumbent exchange's clearing services
is critical to successful entry into trade execution. Competition Commission,
A Report on the Proposed Acquisition of the London Stock Exchange
plc by Deutsche Borse AG or Euronext AV Nov. 26, 2005 at 6.

64. The terms of stock options contracts are effectively
standardized. The terms of other options — like those on indices
and on exchange traded funds — are established in consultation
with the first exchange listing the option. Absent protected intellectual
property rights, other exchanges may offer an option contract on the
same terms.

65. The Department's investigation led to the filing
of a complaint against those exchanges for violations of the Sherman
Act, 15 U.S.C. § 1, and a settlement through the filing of a consent
decree. United States v. American Stock Exchange, LLC, et al.,
Civ. No. 00-02174 (D.D.C. filed Sept. 11, 2000). The complementary SEC
action may be found at SEC Release 43,268, Order Instituting Public
Administrative Proceedings Pursuant To Section 19(h)(1) Of the Securities
Exchange Act Of 1934 (S.E.C. Sept. 11, 2000).

67. Battalio, Robert, Brian Hatch and Robert Jennings,
Toward a National Market System for U.S. Exchange Listed Stock Options
59 J.of Fin. No 2 (April 2004). Multiple listing was followed by
regulatory changes that have furthered competition in options trading,
including rules that have linked option markets and moved the industry
from fractions of a dollar to decimals. Equity options markets are in
the final phases of a transition to pennies as the minimum trading increment,
down from five cents. See U.S. Gov't Accountability Office
Report 05-535, Securities Markets: Decimal Pricing Has Contributed
to Lower Trading Costs and a More Challenging Trading Environment (U.S.
G.A.O. May 2005) at 60.

71. See S.E.C. Release 34-49175, Concept
Release: Competitive Developments in the Options Markets 69 FR
6124 (S.E.C. Feb. 3, 2004). Competition in option trading was
further increased by the move to decimal trading increments and a series
of order handling reforms imposed by the SEC as a consequence of its
investigation.

76. Major electronic equity trading venues provide
trade anonymity which requires that they interpose themselves as the
counterparty to both sides of every transaction. For these trades, a
clearing name is provided by the trading venue.

77. The terms of contracts in specialized securities
— like shares of an exchange traded fund — are controlled
by the originating fund, subject to SEC approval of the listing and
contract terms. Once established, any exchange can list the ETF for
trading, absent intellectual property rights that would permit listing
constraints.

83. Although exchanges have argued that they have
an interest in selecting a sound clearinghouse to protect the public's
faith in their contracts, an exchange has, at best, a secondary interest
in the issue. Clearinghouses act as every trader's counterparty and,
as a result, the clearinghouse has the greatest interest in protecting
against trader defaults.

84. As discussed below, the options regulatory
policy has resulted in the mandated use of a single clearinghouse by
all options exchanges. In equities, SEC policy has permitted use of
multiple, linked clearinghouses, and allowed clearing intermediaries
a more substantial role.